Is oil like a mineral, vegetable or animal?

Remember the game of 20 Questions? One person thinks of a thing. A second person tries to figure out what that something is by asking a series of questions that can be answered yes or no. Typically, the first question is “Are you thinking of a mineral, vegetable, or animal?” Let’s twist the rules; I’ll tell you what I’m thinking but I’ll ask the first question. Ready?

I’m thinking about oil. I want you to guess whether it’s like a mineral, vegetable, or animal. A literalist may cry out “Oil isn’t LIKE a mineral, vegetable or animal. It IS a mineral,” true. But perhaps the question wasn’t asked to find the literal answer but to tease out valid comparisons between all three categories and the current oil situation. There are similarities and differences. Valid comparisons can help us better navigate the potentially bumpy road ahead.

Want a couple clues before answering?

The amount of oil produced each year in the United States peaked in the early 1970s. Since then the annual rate of production has been on a downward trend (the discovery and use of the Alaskan North Shore reserves produced a slight up-tick in the 1980s). We currently produce (bring out of the ground) less than two-thirds of what we did in the early 1970s. To make up for that lost one-third and additional growth, we import almost 60 percent of the oil we consume.

Just as happened in the U.S., many experts now say that the worldwide production of oil is also leveling off and will soon start to decline. Each year the world consumes three times the amount of oil discovered. Obviously we are living off past discoveries. What happens next? Will the discovery rate go up leading to increased production or have we found the majority of earth’s oil?

Few experts suggest we’ll discover enough oil to meet the world’s voracious appetite for this marvelous mineral. Consequently, if indeed the worldwide rate of oil production is starting a long decline, what are the implications for you, me and our society? Allow me to give you the answer — potentially huge! But before getting back to your answer, some more clues.

Minerals

In 1980 Julian Simon, a business professor at the University of Maryland and an author of many economic articles, and Paul Ehrlich, a professor at Stanford, made a famous bet. Would the price of five minerals (copper, chromium, nickel, tine, tungsten) go up or down over the next 10 years? Simon said the prices would be down, in inflation adjusted terms, and Ehrlich said they would go up. The winner would receive the difference between $1,000 invested in 1980 and an equivalent investment based on 1990 prices. Simon “smoked” Ehrlich to the tune of almost $600! What was Simon’s reasoning? Essentially Simon said that as an item becomes scarce, its price in the short run will indeed go up.

However, in a free market this price increase will bring forth a host of changes. People will find substitutes and better ways of utilizing what they have. Solutions will be found to the “problem” of higher prices resulting in lower prices in the long term. Perhaps counter-intuitive, but this fact seems proven in one real world test.

An animal

In 2007, the Canadian Broadcasting Corp. reported the offshore stocks of cod to be only 1 percent of what they were in 1977. The cod have essentially been fished out. Even though Newfoundland established a cod fishing moratorium along its east coast in 1992, stocks remain low. Prices have gone up but, just as Simon suggested, changes have occurred. Cod farming has and is being tried. Substitution is happening; “New” types of fish appear routinely on restaurant menus.

A vegetable

In the mid-1840s a devastating potato blight hit Ireland. By the end of that decade, more than 10 percent of the population had died due to the resulting famine and more than 10 percent had migrated to other countries. Why didn’t a price increase help? The poor couldn’t afford to pay more or buy other foods even if available. Due to very small household farm acreage, only homegrown potatoes offered enough substance to barely sustain people.

In a tragic manner, substitution did work. People substituted other countries for Ireland: they migrated. On an even more tragic note, there was reduced demand; more than 10 percent of the population starved to death.

What about oil?

Now back to my real question. If the rate of oil production is indeed peaking and heading into a long decline, what lessons, what valid analogies can we draw from these three past examples? Is there guidance to be gained about our future — golden or less gilded?

First of all, the economic principles articulated by Simon hold. As items become scarce, a lot of changes happen; substitutes are found and/or items are better utilized. People do adjust. Case closed? Human ingenuity will prevail. Let the oil party continue. Yes? However, before the band restarts, let’s look one more time at the three examples. There are differences.

The Irish potato example is most striking. When there isn’t time for substitutes to be discovered or invented, the results can be catastrophic. With oil, we will find substitutes and better use what we have available —in the long run. In the long run, the price may even go down. But, as one wag put it, “In the long run we’ll all be dead.”

And that is the crux of the issue. In the short term, in this case measured in decades not years, there are no viable, short-term substitutes for oil and its cornucopia of derivatives. For example, look at ethanol, the current alleged great savior. The National Corn Growers Association projects that with increases in technology ethanol could replace 10 percent of expected gasoline demand in 2015-2016. Ten percent! Even if that projection proves correct, the needed infrastructure to handle that much ethanol, on a country wide basis, wouldn’t be ready. And what happens to the other 90 percent of demand? Simon’s other alternative, forced demand reduction, will roll (or perhaps more accurately walk) into action.